[This is the second installment in a series examining index funds. In Part I, we looked at the managed mutual fund market. In this installment, we will look at how an index is calculated and what an index fund is. In Part III, we'll consider how to evaluate index funds and where to buy them.]

In the first part of this series, we saw that mutual funds are the dominant investment vehicle for individuals because they reduce risk through diversification on a scale that individuals cannot achieve on their own. And we mentioned that index funds typically have larger returns and lower fees than managed funds but that investors are largely unaware of their existence.

But why do we have index funds, and what are they?

What is an index?

In order to understand index funds, it's a good idea to understand what an index is. A market index is simply a single number which represents a market and tracks its ups and downs.

The best-known index of all time

The Dow Jones Industrial Average, or the Dow, is probably the best known index today because it has been reported for more than a century by the newspaper which owned it. In the 1880s, Mr. Dow (a reporter) recognized the need for a single number to report the day's activity of the fledgling stock market, so he teamed up with Mr. Jones (a statistician) and calculated the first index. The notion was so successful that the Wall Street Journal, which was owned by Dow Jones, became America's most respected financial news source.

Calculating the Dow

The Dow is calculated by taking the price of 30 of the most actively traded stocks and dividing them by 30. Simple? Not when you start digging.

To begin with, which 30 stocks should you include? Because the Dow is a simple arithmetical average, a $1 change in the price of a $100 stock in the index will change the Dow as much a $1 change in the price of a $10 stock, even though the first one changed by 1 percent and the second changed by 10 percent.

Consequently, the Dow requires the prices of its component stocks to be in a fairly narrow price range. The largest company in the world, Apple, was excluded from the Dow until March 2015, when a stock split brought its price into the Dow's range. Berkshire Hathaway, Warren Buffett's company, will never be a Dow component as long as a single share of its stock costs around $200,000.

The S&P 500 — a more inclusive, more representative index

Despite its notoriety, the Dow represents a tiny fraction of the more than 8,000 stocks that are publicly traded. In 1923, Mr. Standard and Mr. Poor launched their Standard and Poor's 500 index which looks at the total size (market capitalization) of each company. That way, the actual stock price doesn't matter, so it doesn't have to limit its focus. For example, Berkshire and Apple have both been included in the index for many decades now.

Whereas the Dow's 30 stocks cover roughly the top 25 percent of daily trading volume, the 500 stocks in the S&P 500 cover approximately 70 percent. Therefore, the S&P 500 has become the signature index for the stock market.

As interesting as the S&P 500 may be as an index (or the Dow), it is still only a number just like the index of consumer optimism or any one of the hundreds of indexes out there. You can't buy or sell the number, which means you can't invest in it.

So what, then, is an index fund?

Technically, an index fund is a special class of mutual fund, taking investments from individual investors, then pooling them to buy baskets of securities. However, where index funds differ from traditional (or managed) funds is what they buy.

An index fund buys something created to mimic or reflect an index. You can't invest in the S&P 500 index, for example, so an S&P 500 index fund imitates the index by buying all 500 stocks in the index. When you invest $100 in an index fund, you in effect buy a sliver of all the securities (stocks, bonds, etc.) used to calculate that index.

How index funds differ from managed mutual funds

1. They are not managed by “rock star” fund managers. Rather, they are primarily run by computers, which simply buy and sell securities which make up a given index. The index determines what gets bought, not a fund manager.

For example, when an S&P 500 index fund receives a million dollars in cash on a particular day, it buys a million dollars' worth of the 500 stocks making up the S&P index, in the same proportion, at that day's prices. Likewise, they only sell stocks when the fund withdrawals for a day exceed the inflows, and in that case they again sell stocks in the same proportion as the index. An index fund has no favorites.

2. Their costs are far lower because no highly paid experts are needed to research securities constantly in order to try to beat the average. Typically — though not always — they pass those lower costs on to their investors by charging very low management fees. When you buy a mutual fund, any mutual fund, you will receive the returns of that fund, but they will charge you a variety of fees. Index fund fees are usually lower than those of managed funds.

3. They have greater transparency. You can go on the Internet and see exactly what makes up a given index, so you know exactly what the index fund is investing in. You also know that it plays no games; whereas, managed funds are notorious for window dressing at the end of a quarter (meaning they sell things they don't want people to know they owned for most of the quarter, and they buy things which they deem are “politically correct” in their circles to own a few days before the quarter-end, so it shows up on the quarterly report). Index funds, therefore, are easier for individual investors to understand.

4. They perform better than the vast majority of managed funds. For reasons still hotly debated among experts, something like 75 percent of managed stock funds consistently fail to beat the S&P 500. Nobody can predict the future; but with an index fund, you know you're likely to be in the top 25 percent of all funds in terms of performance.

Caveats

Despite the simplicity of the index fund model, all is not so simple in the index fund business, though. Earlier, we mentioned that index fund investing is also called passive investing, because all the fund does is buy and sell whatever underlies the index — computers do all the heavy lifting.

1. Fiddling. That doesn't mean an index fund has no managers, though. As time passed, a few index fund managers started fiddling with the formulas. Why be satisfied with the S&P 500? Wouldn't it be nice to have a juiced-up version which produces twice the growth?

In fact, that is easily done: Just borrow a dollar for every dollar coming in and buy two stocks instead of one. That is called a leveraged index fund. It still carries the label “index fund”; but it is no longer passive, because you have a manager fiddling with the index's formula. The bottom line is there are hundreds of funds out there which carry the name “index fund,” but not all fit the image of the passive fund merely tracking a well-respected index.

2. Pricing. While it's true that an index fund costs less to manage, it doesn't mean they are all priced low. Morgan Stanley, for instance, charges almost five times Vanguard's fees for an identical S&P 500 index fund. Low cost doesn't always mean low price.

3. Limits. The combination of better performance and lower costs have led to significant growth in the popularity of index funds and their exchange-traded cousins, ETFs (Exchange Traded Funds, most of which are index funds). However, despite their recent gains in popularity, index funds only account for about 20 percent of all money managed by mutual funds. Why is that?

One would think that index funds would be the most popular type of mutual fund, given their higher returns and lower costs. One would, however, be wrong: Managed funds still dominate the retail investing landscape.

The mutual fund landscape

The following chart shows two things: index funds' share of total mutual fund assets has climbed; but after all these years, despite the victories of Vanguard's two signature funds, index funds as a whole are still small potatoes, comparatively speaking.

We saw in the first installment that many people simply don't know that index funds exist. But now that we understand what index funds are, we'll turn our attention in the third installment to the final questions: Where do you find index funds, and how do you choose among them?

How did you first learn about index funds? What do you see as advantages as between managed mutual funds and index funds? How important is transparency in your retirement investment accounts to you?

William Cowie spent 30 years in senior management (CFO/CEO) before retiring. He has a bachelor's, a master's, and a partial doctorate in management and strategy. Author of the book “The Four Seasons of the Economy,” William also assists medium-sized businesses in the use of the Four Season Strategy to help them capitalize on economic cycles. He runs two blogs: Bite the Bullet Investing (investing) and Drop Dead Money (the economy) and writes for several other blogs in addition.

Good description, but I don’t think most index funds actually buy every stock in the entire index. Instead, they buy a mix of stocks that mimics the overall index.

I don’t think there are any advantages to managed funds. But our legal and regulatory environment is set up to benefit the finance industry. How else do you explain “tax deferred” retirement accounts whose net tax benefits, compared to Roth type accounts, go entirely to the finance industry.

This is a great overview! I first learned about index funds when I graduated from college and began researching how to invest my savings for retirement. I currently invest in several index funds, and I am primarily attracted by the low fees. I am a buy and hold investor, focused on growth over an extremely long time horizon. For me, index funds make the most sense because I’m not looking for quick wins and I don’t want high fees to eat my returns over time.

It’s interesting to note that many people who dislike index funds argue that they can do better with astute investing. Perhaps they can, although from what I can see it takes an inordinate amount of work (or else a lot of unethical behavior) to beat the index funds, especially over the long term. Given the fact that a high percentage of managed funds don’t do better than index funds, especially over the long run, the chances that any individual will do so seem rather low.

One can compare investing with gambling in casinos. Who makes the real money from casinos? The owners of the casinos! They win some and lose some but base their payout rates on statistics and, on average, come out very well. This is comparable to what happens to the investor in index funds. No spectacular wins but no spectacular losses and, in the end, you come out quite well because the odds are with you. In the meantime, thousands of people go to casinos hoping or even believing they will come out ahead but few do and almost nobody does so consistently over a long period of time. The odds are simply not in their favor. Ditto for those who invest in managed funds.

I have invested in managed funds and index funds over a 40 year period and have detailed records for the past 35 years. Index funds were rare when I started so initially I was all in managed funds. But over time the index funds played a bigger role and when you look at the long term return, the index funds win hands down.

A vivid explanation on index funding! Since we are all looking to increase our wealth, we may as well seek the advice of a good investor. Today many businesses are receiving tremendous benefits by implementing factoring as part of their financial strategies.

Really enjoyed this post because it highlights some of the fallacies with the DOW and S&P 500, helps us understand where our dollars are going inside an index fund. Maybe it’s a desire to trust fellow humankind over an automated investment index, or maybe it’s just greed that motivates — I’ve always found it interesting that many are willing to invest in actively managed funs and pay a guaranteed cost for an uncertain “promised” boost in return.

Looking forward to the last post in the series! Also just looked up your explanation of ETF index fund and learned quite a bit there too.

Your email address will not be published. Required fields are marked *

Comment

Name *

Email *

My name is J.D. Roth. I started Get Rich Slowly in 2006 to document my personal journey as I dug out of debt. Then I shared while I learned to save and invest. Twelve years later, I've managed to reach early retirement! I'm here to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you get rich slowly. Read more.

General Disclaimer: Get Rich Slowly is an independent website managed by J.D. Roth, who is not a trained financial expert. His knowledge comes from the school of hard knocks. He does his best to provide accurate, useful info, but makes no guarantee that all readers will achieve the same level of success. If you have questions, consult a trained professional.

Advertising Disclosure: Some offers on this page may promote affiliates, which means GRS earns a commission if you purchase products or services through the links provided. All opinions expressed here are the author's and not of any other entity. The content at Get Rich Slowly has not been reviewed, approved, or endorsed by any entity mentioned at the site. For additional information, please review our full advertising disclosure.